Notwithstanding some volatility over the June quarter, fixed income markets remain caught between stretched valuations – whether of sovereign rates or credit spreads – and an ongoing hunger for yield. The hunger for yield, which contributes to the expensiveness of assets, is supported by stability of economic outcomes - around trend growth and subdued inflation - and by the predictability of central bank policy responses, which together have kept market volatility low. Not much has changed in this causal loop over the last several years – economic outcomes have stayed moderate, central banks have stimulated more, and financial assets have become more expensive.
The key conundrum is why all the policy support has not produced a stronger economic response. In part we know the answer: there is still too much debt, and both the willingness to lend (due to impaired banking systems and regulatory constraints) and the willingness to borrow (especially by corporates to invest) have been low. Emerging economies have suffered similarly from high debt levels and a lack of demand from the west, and more recently currency and commodity price shifts are exacerbating imbalances. Economists have also recently been marking down estimates of long run growth in part because of these ‘debt overhang’ issues, as well as the issues around aging of western populations.
The related conundrum is the extent to which financial markets may ultimately be becoming more vulnerable as a result of all the stimulation, which effectively is staying mostly within financial markets rather than being redeployed in the ‘real economy’. Drawing the conundrums together, the world’s key central bank, the US Fed, does appear to be moving towards a position where it feels it needs to tighten policy – in part because the US economy has sufficiently recovered that zero rates are no longer required (but policy is still likely to remain very accommodative), and in part because asset expensiveness combined with lower growth potential leave it little firepower to stimulate in future if it doesn’t create room to do so.
We therefore appear to be approaching a point at which something gives – a change in central bank behaviour may lead to a material cheapening of asset prices. Arguably we are already witnessing some of the moves; USD strength is pressuring a range of dollar-linked and commodity-dependent economies, credit spreads have been moving wider as corporates issue more to lock in low rates, and volatility has been ticking up. While we don’t claim superior insight on the timing of Fed moves or other market-disruptive events, we do have a relatively upbeat view of the US economy, and suggest it could be ‘sooner rather than later’.
All this leaves us with a portfolio that is defensively positioned, and increasingly so. We continue to run interest rate duration at 1.7 years shorter than benchmark, primarily because core sovereign bond yields remain considerably below fair value levels. Most of our short position is in the US, reflecting our view that the US leads the cyclical recovery among developed economies, while we also have smaller short positions in Germany and Australia (the latter of which also constitutes a material long absolute Australian duration position given our relatively downbeat views about the domestic economy). Across the yield curve our short exposures are roughly evenly distributed to protect both against Fed hikes causing repricing at the short end, as well as a possible rebuild of global term premium at the long end.
We have also reduced credit exposure materially recently, on top of the progressive reduction in credit that we’ve made over the last couple of years. Our recent reductions have mainly been from our global investment grade corporate exposures, which at current valuations – though not excessively rich - are not especially insulated from growing concerns around reduced liquidity and increasing volatility. This reduction takes us now to only a modest overweight credit exposure, and has seen effective cash build up to more than 30%. We also continue to run a collective underweight position to the non-credit spread sectors (i.e. semis and supras) given the modest additional return they offer versus governments ahead of looming uncertainties.
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